Emerging Market Stock Slump Only Half Over, Deutsche Bank Says

By Ben Levisohn

To the chagrin of many, emerging markets have been trailing developed ones for a while now. Expect the disappointment to continue, Deutsche Bank says, as most big investors are only beginning to acknowledge the regions slower growth.

Reuters

The MSCI Emerging Markets Index has returned 2.3% including reinvested dividends and price appreciation during the past two-and-a-half years, to the MSCI World’s 30.4%. The S&P 500 has gained 45% during that time period. And in a report today Deutsche Bank’s John-Paul Smith and Priyal Mulji make their case for the sluggish performance to continue.

It all starts with China. While some investors see capital inflows giving China’s stock market a boost, Smith and Mulji see its poor economic performance continuing, as capital inflows fail to overcome what they term China’s “deeper structural malaise.”

And as China goes, so do the emerging markets. They write:

If our bearish China view proves to be correct, further EM underperformance against DM/US appears inevitable, through the impact on China and her Asian trading partners, as well as the commodity producers. The precise impact on financial markets in absolute terms depends on the extent to which the transition to a lower growth rate is an orderly process. Overall, we reckon that we are around halfway through the secular underperformance cycle of GEM based on our China hypothesis, the ongoing redistribution away from capital in key markets and the fact that most retail and institutional end clients of dedicated managers have not yet begun to unwind their positions.

Smith and Mulji see two possible scenarios. In the first, China’s slowdown occurs in an orderly fashion, as investors put new money to work in developed markets and emerging markets will steadily underperform developed ones. In that case China, Russia and Brazil’scheap valuations would do them little good, and countries like India and Turkey would do well in “absolute and relative terms.”

But there’s another, more frightening scenario. Smith and Mulji write:

On the other hand, if the China bear case unfolds in a more dramatic fashion, then some of the more expensive markets, such as Mexico, Indonesia and Thailand, which have been bought by the better-performing funds, could be highly vulnerable if these same funds suffer redemptions. The markets which have become dependent on foreign portfolio inflows to finance high current account deficits would also suffer in this scenario, in particular India, South Africa and Turkey. This could lead to the somewhat perverse phenomenon that some of the fundamentally, better-placed markets might underperform their more structurally challenged peers for a time.

Their advice:

… maintain the underweight in GEM equities and to favour US assets within an overweight DM position. If forced to be a little more specific, we would guess that we are around half way through a multi-year period of secular GEM underperformance in percentage terms, given that the increased level of caution on the part of dedicated investors has yet to be matched by their end clients, both retail and institutional.

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